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Passive Income vs Residual Income

Passive Income vs Residual Income: What’s the Difference?

By / October 20, 2022

Table of Contents

Let’s start small. Income is money a business entity or a person receives in exchange for an investment. While income has many types, the two most discussed are passive and residual income. These are two forms of revenue that, separately or together, can have a sizable effect on a person’s finances. Often these two terms are used interchangeably, but they have pretty distinct differences that we’ll discuss before we take a look at their basics.

Passive IncomeResidual Income (RI)

The meaning of residual income depends upon the context. In terms of corporate finance, it is the surplus that an investment earns after the capital’s opportunity cost (OC) is subtracted.

But in equity valuation’s context, residual income refers to the net income after all the stockholder’s opportunity cost used in generating income is accounted for.

Furthermore, it measures the tangential profits. That is, what a person has earned after subtracting all the capital costs spent to generate that income. It is also known as abnormal earnings, economic value-added, and economic profit.

Types of Residual Income

There are three types of residual income:

  • Corporate Finance: As mentioned above, in the corporate world, RI is the amount of leftover operating profit when capital costs have been used. In terms of its formula, it is the amount of excess profit against the rate of return or a company’s net operating income. Here it is used to assess the performance of capital investment. To calculate residual income, the below formula is used:

RI = Controllable Margin – Average Operating Assets * Required Rate of Return.

The Controllable Margin is the project’s revenue minus variable expenses. Average Operating Assets are the resources required to assist the company’s operations. Finally, the Required Rate of Return is the minimum return that a company is inclined to accept from a given investment.

  • Stock Valuation: The residual income valuation model estimates the country’s intrinsic value of the common stock. This valuation method is the profit gained when all capital sources’ opportunity costs are deducted. 

One can easily alter it, depending on the cost of equity. The companies are assessed based on the sum of their present value and the book value of expected future residual income. Company owners can measure RI through the following formula:

RI = Net Income – Equity Charge

  • Personal Finance: Here, the residual income is called discretionary income. Once an individual has paid all the outstanding debts, i.e., car loans and mortgages, the remaining amount is the residual value. In personal finances, it is an important metric that lenders and banks look at before approving any loan. Additionally, it helps to determine whether the individual is making enough money to fulfill his expenses and even secure an additional loan. To successfully get a loan approved, you would need a high RI.

 

Passive Income

Passive Income 

Here, the earnings are derived from a limited partnership, rental property, or other enterprises without active involvement by the owner or investor. Retirement savers and investors highly value passive income. It allows them to increase capital without devoting funds, time, or energy. 

Common sources of this income are accounts or bonds, interest from savings, rental income from real estate, and stock dividends. It can also be the royalties paid to an author, freelancers earning online, and tuition fees charged by people who take online courses. 

If enough passive income is generated, an investor can retire early and reduce the hardships one may face if salaries or wages from jobs are interrupted.

Types of Passive Income

Types of passive income include self-charged real estate (rental) properties and ‘no material participation’ in a business. 

  • Self-Charged Interest: Here, passive income takes the form of the money loaned to an S corporation or a partnership that acts as a pass-through entity by its owner. 
  • Rental Properties: The rental income that real estate professionals make counts as passive income. 
  • ‘No Material Participation’ in a Business: Here, your participation is limited to investing. However, if you helped manage where you invested, the money earned is active income. 

 

Differences Between Passive & Residual Income

Here are some basic differences between passive income and residual income.

Participation

Passive income involves investment paid upfront in money, time, or skill set. This is the same as finding and letting tenants live on your property. It requires no maintenance.

In contrast, residual income requires maintenance. An example is an online academy creating an online course. They would have to update it regularly for new accounting regulations. 

Residual IncomeOptions

There are many passive income streams, but all require an in-depth understanding and expertise of the topic. Producing passive income requires a certain skill set, i.e., investing. It can also be created through cryptocurrency.

There are more diverse options to create residual income. You can effectively increase residual income by managing your money more efficiently and lowering household debt. It focuses on managing pre-established finances and providing a service to produce more free income.

Risk

The risks involved in generating passive income vary based on the source. For example, a landlord can experience risk in the form of loan defaults or tenant damages. Additionally, investors who earn passive income through trading or stocks can experience financial risks if the prices fall. 

However, residual income involves minimal risks. This is because this income is the leftover capital after meeting financial obligations.

Financial Security

Although both help individuals establish independence and financial security, passive income has a much greater effect. For example, real estate agents can generate around $600 to $2,000 as monthly income by renting property.

Residual income rarely offers financial security. For example, a person can finish their car or household debt by $500 per month. This creates a residual income of $400. 

Conclusion

Some people refer to ‘passive earnings’ as ‘residual income, money earned with little or no effort. However, the two are hardly interrelated since the wording could mean quite different things. Hopefully, this guide helped you gain a more in-depth understanding of both residual and passive income. Now you’ll be able to better differentiate between the two.